The Gold Standard, and the Myth About Money Growth

Nathan Lewis
, ContributorI write about monetary and tax policy for the 21st century.Opinions expressed by Forbes Contributors are their own.

Among the silliest things that people say about gold standard systems is that under them, the “money supply” grows about 2% per year, due to mining. This is demonstrably false – not only that, but so utterly wrong as to induce falling-off-the-chair guffaws from those who understand such things.

Doesn’t anyone know how to play this game?

I like to take the example of the United States. In 1775, the total amount of currency in circulation (primarily gold and silver coins) was an estimated $12 million. In 1900, it was $1,954 million – an increase of 163x!

During this time period, the amount of gold in the world increased by about 3.4 times, due to mining production.

Obviously, the two have nothing at all to do with one another. If you were to take similar statistics, from Italy or Britain or France or Germany, you would find that the growth of the money supply in those countries was completely different than that of the U.S., although all of them used a gold standard system.

For example, between 1880 and 1900, the monetary base in Italy actually shrank by 4.8%. However, the monetary base in the U.S. grew by 81% over those same years. Both used gold standard systems. So, the “money supply” not only has no relation to gold mining production, but two countries can have wildly different outcomes during the same time period.

The value of the dollar was about the same in 1775 and 1900, approximately $20 per ounce of gold (or a dollar worth 1/20th ounce of gold).

So, what’s going on here? The important thing about gold, as a basis for monetary systems, is that its value is stable. Certainly, one important reason why its value is stable is that the quantity of it in the world doesn’t change much – only about 2% per year. Unlike virtually all other commodities, the amount of gold in inventory is vastly in excess of its annual production. This makes gold singularly insensitive to variations in supply.

However, a gold standard system can make available any amount of currency, as is appropriate given economic needs and the fixed parity value. Just as the U.S. economy grew enormously in the 1775-1900 period, the gold standard system allowed the money supply to also grow enormously, as was appropriate at the time.

Previously, we looked at exactly how this could work, with an example of a very simple 100% reserve, bullion warehouse receipt-type system, hypothetically applied to Belize. Here you can see how the gold standard system can expand and shrink the money supply as appropriate, as part of the mechanism that maintains the value of the currency at its parity rate.

Unfortunately, some gold standard advocates have been somewhat devoted to this “money supply growing at 2% a year” stuff. Naturally, their critics, the academic Keynesians, are quick to note that an economy might need more than 2% year money supply growth, as the U.S. economy did in the 19th century. Alas, the gold standard advocates have painted a big “kick me” sign on their back. What do you think is going to happen next?

Actually, these discussions date from quite a while back. What’s really at issue here is not the ability of a gold standard system to expand and accommodate a growing economy if necessary. Obviously the money supply grew a very large amount in the U.S. during the 19th century, and obviously the gold standard system did not hold back economic development. The United States was the greatest economic development story of that century. When you want to make an example of failure, you usually don’t choose the reigning World Champion.